Capital Investment and Variance Risk Premia

77 Pages Posted: 13 Jul 2016 Last revised: 30 Sep 2020

See all articles by Jan Ericsson

Jan Ericsson

McGill University; Swedish Institute for Financial Research (SIFR)

Evan Jo

Queen's University - Smith School of Business; McGill University - Desautels Faculty of Management

Babak Lotfaliei

Carmona College of Business

Date Written: July 1, 2016

Abstract

We document that the variance risk premium in asset returns decreases firms’ investments.
We theoretically model the premium; we find that it increases the value of the real option
to delay an investment and, thus, influences investments negatively. Empirically, we verify
the negative link between the variance risk premium and investments. Cross-sectionally, the
link is more important for investment-grade firms, which have relatively higher exposure
to systematic variance risk. This premium helps us understand an otherwise surprising
pattern: investments are lower for investment-grade firms with better investment conditions
than speculative-grade. Investment-grade firms basically hedge variance risk by delaying
investment.

Keywords: Real option, Variance risk premium, Optimal timing, Stochastic volatility

JEL Classification: D81, G13, G31

Suggested Citation

Ericsson, Jan and Jo, Evan and Lotfaliei, Babak, Capital Investment and Variance Risk Premia (July 1, 2016). Available at SSRN: https://ssrn.com/abstract=2808765 or http://dx.doi.org/10.2139/ssrn.2808765

Jan Ericsson

McGill University ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada
(514) 398-3186 (Phone)
(514) 398-3876 (Fax)

HOME PAGE: http://people.mcgill.ca/jan.ericsson/

Swedish Institute for Financial Research (SIFR)

Drottninggatan 89
SE-113 59 Stockholm, SE-113 60
Sweden

Evan Jo

Queen's University - Smith School of Business ( email )

Smith School of Business - Queen's University
143 Union Street
Kingston, Ontario K7L 3N6
Canada

McGill University - Desautels Faculty of Management ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada

Babak Lotfaliei (Contact Author)

Carmona College of Business ( email )

7400 Bay Road
University Center, MI 48710-0001
United States

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